Will online lenders disrupt small business banking?

This is the conclusion of a four-part viewpoints series by CCG Catalyst's Paul Schaus regarding banks versus fintech players. Banking Exchange welcomes your comments on this series, either in the comment section below this article or in an email to [email protected]

The credit crunch hit small businesses hard after the recent financial crisis, as banks sharply pulled back on lending. That drop in lending activity opened the door for alternative lenders to enter consumer lending, and the same thing is happening in small business lending.

But the opportunity for new entrants in the small business space is greater. That’s because small businesses have more urgent credit needs than consumers. They don’t just need credit, they need it fast. New entrants have proven they can provide it more quickly and with less hassle than traditional banks.

Finding a need, and filling it

A 2013 study by the Federal Reserve found that access to capital is the top growth concern for small business owners. That’s no surprise. The number of new small business loans of less than $100,000 originated in 2012 was almost half the number originated in 2008, according to the U.S. Small Business Administration.

Not only are banks limiting access to credit, but the process of getting a small business loan takes weeks and piles of paperwork. Given that small business customers are more profitable than retail consumers, banks should be making it easier for their small business clients to get credit. Instead, it’s the new entrants who have figured out how to help small businesses quickly get credit when they need it through online platforms and analytics.

That’s bad news for banks that need to retain business from this profitable customer segment. It’s not the end of the world, though.

The new entrants still make up a tiny fraction of the overall market. As of last year, alternative lenders had issued about $10 billion of small business loans, compared to a total market worth $600 billion. The huge size of the market has attracted a variety of new entrants looking to disrupt it, and banks have a lot of opportunities to partner with some of them.

What business loan disrupters look like—and play like

The new entrants in small business lending can be split into two groups: those that connect small businesses to lenders, and those that actually provide credit themselves.

Potential partners. The first group includes P2P lending platforms like Prosper and Lending Club, which I’ve covered previously in Part 1: "Who will consumers choose?" It also includes sites like Lendio and Fundera that help small businesses shop for loans from both traditional and alternative lenders.

Banks should view this first group as an opportunity to connect with small businesses that need credit. Instead of going out to find qualified borrowers, banks can use these sites to let borrowers come to them. Most of the loans originated through P2P sites now come from traditional lenders like banks, and there are now tools that can help banks find the least risky loans on those sites. Besides, default rates on loans issued through Lending Club and Prosper are similar to those of loans issued directly from banks.

Prosper's business model makes it a potential partner for your bank.

It’s no secret that risk is what is holding banks back from lending to small businesses. Small business loans of more than $1 million—loans that typically go to larger, more stable businesses—have returned to close to the numbers seen before the Great Recession. Meanwhile, by comparison, loans to small merchants that have a greater risk of going out of business have dried up.

Here’s the strategy: Banks can leverage this first group of new entrants as a channel to help find new customers more cheaply.

Definite competitors, and some potential partners. The second group of new entrants that provide credit themselves includes some players that may be willing to partner with banks—and some that definitely are not. The list of new alternative lenders for small businesses includes specialized small business lending sites like Kabbage and OnDeck Capital, as well as bigger names like Square, PayPal, and Amazon. [Read "Will Square swipe banks' business?"]

The first group of specialized lending sites may be willing to work with banks to grow their business. These sites have been around for a while, and have established online lending platforms with algorithms that help them determine credit worthiness and loan terms. Those algorithms are being refined over time too.

If banks want to compete with these sites (as well as the bigger names mentioned above) they will need to build their own competing online platforms and analytics tools. Banks might decide that it is easier to try to partner with or acquire one of these specialized small business lending sites rather than build out that technology on their own. MasterCard inked a partnership with Kabbage earlier this year to allow acquiring banks on MasterCard’s network to use Kabbage’s technology to offer small business loans. (See “Kabbage hopes to harvest more bank partnerships”)

On the other hand, Square, PayPal, and Amazon are much less likely to seek such partnerships because they already have a captive market—the millions of merchants who already use their services.

Square and PayPal have a ton of data on merchants who use their credit card processing services. Amazon similarly knows all about the sales volume, inventory, and even customer satisfaction of Amazon merchants. These companies can crunch all of that data to determine the credit worthiness of these merchants, and they have plenty of cash to lend.

So offering loans to their merchants is a low-risk proposition, and they have no need to partner with traditional lenders to help them grow. That means that these organizations will be banks’ most ardent competitors in small business lending in the future.

These organizations will have several advantages going forward. They will continue to refine their analytics that determine loan terms. PayPal Amazon, and Square also have brand names that small businesses recognize, and many small businesses already depend on their services.

PayPal, with an embedded merchant base, is much less likely to see banks as partners.

It’s probably more convenient for an Amazon seller to get a loan through Amazon than through their bank, especially when Amazon delivers the funds to their seller account within five days.

Most importantly, all three of these companies will become even more embedded in the small business market as digital transactions continue to grow.

More businesses will sell on Amazon and use PayPal for digital transactions as e-commerce takes up a bigger share of total retail transactions over the next few years. eMarketer predicts that share will grow from 5.9% of the global retail market last year to 8.8% in 2018.

Square will similarly benefit from continued growth of mobile point of sale terminals, which are making credit card processing more accessible for small merchants. As more small businesses use Amazon, PayPal, and Square, the pool of merchants that they can lend to will grow.

Where to from here?

Banks will have to respond by taking their own small business lending operations digital, either by building, partnering with, or acquiring the platforms that will help them determine credit worthiness and issue loans faster.

Banks will also need to be closer to their small business clients than ever before. Small business owners don’t just want a bank account and credit; they want advice to help them grow. [Read Ed O’Leary’s blog, “No app can do what you do, in person”]

Banks can deliver that advice using all of the data they already have on their small business customers and analytics tools that can give these small businesses the insights they’re looking for.